At the PNBA’s Annual Lawyers’ Liability Seminar on 11 October 2014, Michael Pooles QC delivered a lecture addressing what he modestly described as a pot pourri of novel or recurrent issues relevant to professional liability claims. One of these issues in particular caused a rather sharp collective intake of breath from the lawyers present, since it concerned what Mr Pooles termed “the most significant potential elephant trap to have been devised for the unsuspecting advocate for a number of years.”
The danger in question arose on 27 January 2014, when HMRC made a very slight – but potentially very significant – amendment to one of its Extra Statutory Concessions.
The concession in question is ESC D33 and it has been in place since the late 80s. One of its effects, prior to 27 January 2014, was that awards of damages and settlement sums were not subject to capital gains tax (CGT) where the recipient of the award was an individual or corporation tax where the recipient was a company. That has now changed.
To understand the effect of ESC D33 both before and after January 2014, it is necessary to look back at the case of Zim v Proctor [1985] STC 90. There, a sale of the claimant’s (or, in those halcyon days, the plaintiff’s) property had fallen through due to the negligence of its solicitors (the claimant had been unable to demonstrate good title to the property). The claimant and its solicitors had managed to agree a settlement. HMRC then sought payment of corporation tax on the whole settlement sum on the basis that it represented a chargeable gain. The claimant argued that, if it had to pay tax on the settlement sum at all, such tax should be assessed by reference to the underlying property (that is, the gain that would have been realised had the property actually been sold).
Warner J found in favour of HMRC and the entire settlement sum was subject to tax as a chargeable gain. He held that the relevant asset for tax purposes was the claimant’s right of action (against the solicitors) and not the property which should have been sold. As such, the ‘gain’ to be taxed was the difference between the market value of the right of action at the date of its acquisition and the sum for which it was ultimately realised (subject to any allowable expenses or deductions, etc).
Following Zim, HMRC put in place ESC D33. It had two main operative paragraphs. Paragraph 9 dealt with the case where there is an ‘underlying asset’, such as the property which should have been sold in Zim. In such cases, an award of damages or a settlement sum is assessed to tax by reference to the underlying asset. So, in Zim, the claimant’s ‘gain’ would be calculated by reference to the acquisition cost and (intended) sale price of the property and not by reference to the right of action itself. HMRC has not changed – and has not suggested that it is going to change – paragraph 9 of the concession.
However, paragraph 11 dealt with the case where there is no ‘underlying asset’ which can be used to calculate the amount of tax due on damages or a settlement sum. The classic example of this might be negligent tax advice, where a tax adviser’s client ends up paying too much tax as a result of the adviser’s negligence. Indeed, negligent tax advice has been given as an example of a ‘paragraph 11’ case by HMRC itself.
For almost thirty years, paragraph 11 of ESC D33 provided that awards of damages or settlement sums in cases which involved no underlying asset were simply exempt from CGT or the equivalent corporation tax.
It is difficult to disagree with Mr Poole’s comment that paragraphs 9 and 11 (pre-January 2014) appeared “both logical and just”. On 27 January 2014, however, and apparently without prior consultation or warning, HMRC removed the exemption in paragraph 11.
In doing so, HMRC replaced the blanket exemption in paragraph 11 with a ‘fixed cap’ of £500,000. Any awards of damages or settlement sums over that limit may now be subject to CGT or corporation tax. HMRC has a discretion in respect of such higher sums, but notes on its website that it “will not normally provide relief above that amount [i.e. £500,000].” Importantly, anyone who receives compensation of more than £500,000 should notify HMRC accordingly. If that party thinks their award should not be chargeable to capital gains tax, they may make a claim for relief. It remains to be seen how HMRC will apply its discretion in practice, particularly as the end of the tax year approaches.
In the meantime, HMRC has proposed changing paragraph 11 again. In a consultation paper published in July 2014, it proposed lifting the fixed cap to £1 million. Any award above this amount would automatically be considered a chargeable gain; HMRC would have no discretion to grant relief.
It is not difficult to imagine situations in which this proposed regime might result in injustice. Take an example where an individual has paid £2 million too much tax as a result of negligent tax advice. The unfortunate individual sues his adviser and recovers the £2 million. Then HMRC steps in and taxes (at the current CGT rate of 28%) the top £1 million slice of his £2 million award. The individual would remain out of pocket by as much as £280,000. Happily, however, the public purse has made a windfall of (overall) around £2,280,000.
Interestingly, the economic assessment which accompanied HMRC’s July consultation stated that the proposed further amendment to the concession was “expected to have a negligible impact on the Exchequer”; although it acknowledged that there “may be an impact on individuals and companies receiving compensation of more than £1 million.”
HMRC’s consultation ran for around six weeks and closed on 15 September 2014 (HMRC said it was running a shortened consultation period on the basis that it was “largely a technical consultation [about] a long standing concession with which professionals are familiar”).
Possibly as a result of this shortened period, HMRC received fewer than 20 responses. Although HMRC refused this author’s FOI request for copies of those responses, many of them are available on the websites of the various respondents themselves. They raise a number of concerns with HMRC’s proposals. The Law Society, for example, pointed out that, with respect to compensation, there is “no difference in the analysis between (properly incurred and claimed) compensation of £300,000 or £37 million. Compensation is compensation of actual loss, whatever the cash figure involved.”
The Law Society was also concerned about the lack of ‘grandfathering’ provisions in the HMRC consultation. It warned that, absent such provisions, HMRC is “likely to be accused of retrospection”.
The Law Society’s two responses to the consultation are both available on its website, and are well worth reading.
Two issues remain to be discussed, albeit briefly. The first concerns the scale of the problems caused by the amendment to paragraph 11 of ESC D33; the second concerns the legal profession’s likely response to it.
As to the first of these issues, the scale of the problem obviously depends upon how many cases exist which are worth more than £500,000 (or, should HMRC’s proposals come into effect, £1 million) and do not involve an underlying asset to which the CGT or corporation tax can attach. The obvious example, as set out above, is negligent tax advice, but there may be other categories of cases as well. Practitioners should therefore be alive to the consequences of the new paragraph 11 when dealing with cases which do not (or may not) contain such an underlying asset.
It is worth noting that, in its response to HMRC’s consultation, the law firm Mishcon de Reya stated that it deals “with high value litigation matters on a daily basis and it is certainly the case that the rights of action in those matters cannot always be linked to underlying assets.”
The second issue concerns how practitioners should respond when dealing with a high value case not involving an underlying asset. If the claimant faces being taxed on their compensation, the obvious solution may be to claim the compensation plus the tax that will (or may) have to be paid on it. As such, claims may have to be grossed up to as much as 139% of the compensation sought so that, if 28% CGT is applied to the total sum, for example, the claimant is left with the full amount.
Defendants will presumably respond by arguing either that they should not be liable to compensate the claimant for this tax at all or that, at the very least, the claimant will never have to pay the full amount of tax – because it may, for example, be able to claim allowable expenses (possibly including its legal costs in the very proceedings by which the compensation is claimed).
It may be tempting for the claimant to include in their pleadings a ‘boilerplate’ clause seeking an indemnity from the defendant in the event that HMRC decides to tax the damages; however, might the payment of such an indemnity itself be subject to CGT or corporation tax?
It should go without saying that this is a murky area where tax and professional negligence collide, and accordingly specialist tax and/or civil litigation advice should probably be sought in cases which may fall foul of the revised ESC D33. It should also be noted that certain claims remain exempt from this form of tax (most obviously claims involving personal injuries, which are excluded by statute). For other claims, the ghost of Zim now stalks this land.
Martyn Naylor
4 Pump Court